Direct taxation : Communication on the
application of anti-abuse measures – within the EU and in relation to
third countries – Frequently Asked Questions

According to the doctrine of abuse of rights developed by the ECJ in its
(mainly non-tax) case law, abuse occurs only where the purpose of law is
defeated despite formal observance of the conditions laid down in the law, and
there is an intention to obtain an advantage by artificially creating the
conditions for obtaining it.

On direct taxation, in addition, the ECJ has held that the need to
prevent tax avoidance or abuse can constitute an overriding reason in the public
interest capable of justifying a restriction on fundamental freedoms. The notion
of tax avoidance is however limited to wholly artificial arrangements
aimed at circumventing the application of the legislation of the MS
concerned.

Tax avoidance or abuse needs to be distinguished from tax fraud which
involves deliberate unlawful behaviour which is generally punishable by law
(e.g. submission of deliberately false statements or fake documents).

What are anti-abuse rules?

The notion of "anti-abuse rules" covers a broad range of rules, measures and
practices through which Member States seek to protect their (corporate and
individual) tax bases. For example, MS may apply a general concept of abuse
based on legislation or developed in case law and/or more specific anti-abuse
provisions, such as Controlled Foreign Corporation (CFC) and thin capitalisation
rules which aim to protect the tax base from particular types of erosion (see
below). Other types of specific anti-abuse provisions include, for instance,
switch-over from exemption to credit method in certain cross-border situations
and provisions explicitly targeted at passive investment in other countries.

What are Controlled Foreign Corporation (CFC) and thin capitalisation
rules?

These are the most common types of specific anti-avoidance rules with which
many MS seek to protect their tax bases against particular types of cross-border
tax avoidance schemes. In brief, their scopes and objectives could be summarised
as follows.

CFC rules: The main purpose of CFC rules is to prevent resident
companies from avoiding domestic tax by diverting income to subsidiaries in low
tax countries. The scope of CFC rules is generally defined by reference to
criteria regarding control, effective level of taxation, activity and type of
income of the CFC. They typically provide that profits of a CFC may be
attributed to its domestic shareholders (usually a parent company) and subjected
to current (immediate) taxation in the hands of the latter (whereas normally the
parent company would be taxed on the profits of its foreign subsidiary only at
the time of repatriation).

Thin capitalisation rules: There are many different approaches
to the design of thin capitalisation rules but the background to these rules is
similar. Debt and equity financing attract different tax consequences. Financing
a company by means of equity normally results in a distribution of profits to
the shareholder in the form of dividends, but only after taxation of such
profits at the level of the subsidiary. Debt financing, in turn, will result in
a payment of interest to the creditors (who can also be the shareholders), but
such payments generally reduce the taxable profits of the subsidiary. Dividend
and interest may also attract different withholding tax consequences. As the
source state's taxing rights on interest are generally more limited than on
dividends, debt financing can lead to the erosion of the tax base in the state
of the subsidiary. To counter this problem, many MS have introduced specific
thin capitalisation provisions dealing with structured debt financing schemes.
Typically these limit the deductibility of interest paid on loans taken with (or
otherwise arranged by) shareholders to the extent that the subsidiary is
considered to be excessively "thinly" capitalised.

Why has the Commission issued this Communication?

As with other coordination initiatives in the direct tax field the obvious
catalyst for the need to address issues related to the application of MS'
anti-abuse rules lies with the development of the European tax law. Over the
past few years the European Court of Justice (ECJ) has handed down a number of
important judgments in this area in which it has clarified the limitations on
the lawful use of anti-avoidance rules. The judgments will have a significant
impact on the existing rules which have not been formulated with these
constraints in mind. There is thus a need for a general review by MS of their
anti-avoidance rules.

While it is important to ensure that there are no undue obstacles to the
exercise of the rights conferred upon individuals and economic operators by
Community law provisions, MS also need to be able to operate effective tax
systems and prevent their tax bases from being unduly eroded because of
abuse.

It is also vital that MS avoid overreacting to the case law. It would be
regrettable if, in order to avoid the charge of discrimination, MS simply
extended the application of anti-abuse measures designed to curb cross-border
tax avoidance to purely domestic situations where no possible risk of abuse
exists. Such unilateral remedies only add unnecessary red tape – and thus,
they undermine the competitiveness of the MS' economies, and are not in the
interest of the Internal Market. Moreover, it remains debatable whether such
extensions can successfully bring all restrictive measures into line with MS' EC
Treaty obligations

Moreover, and notwithstanding the guidance laid down by the ECJ to date,
there remains scope for exploring the practical application of the relevant
principles beyond the circumstances of the particular contexts in which they
arose. The Commission therefore wishes to invite the MS and other stakeholders
to work with it to promote a better understanding of the implications for MS'
tax systems.

Is there (still) scope for application of anti-abuse measures within the
EU/EEA?

As the ECJ has confirmed in a number of occasions, the need to prevent tax
avoidance or abuse can constitute an overriding reason in the public interest
capable of justifying a restriction on fundamental freedoms. But in order to be
lawful national anti-avoidance rules must be proportionate and serve the
specific purpose of preventing wholly artificial arrangements. It is in
particular clear that those rules must not be framed too broadly but be targeted
at situations where there is no genuine establishment or more generally where
there is a lack of commercial underpinning.

It is clear from the case law of the ECJ that, for instance, CFC and thin
capitalisation rules are generally apt to achieve their intended purpose and
that they are not per se incompatible with the EC Treaty freedoms.
However, such rules must be accurately targeted at situations of abuse and
proportionate to the objective of preventing abuse.

Moreover, as Community law does not require MS to avoid discrimination in
relation to the establishment of their nationals outside the Community, or the
establishment of third-country nationals in a MS the issue of discrimination
does not arise, for instance, in the cases of a controlled company or a
creditor/shareholder resident in a third country. MS should therefore not be
precluded from applying CFC and thin cap rules in relation to third countries.

How does this initiative relate to those on "harmful tax
competition"?

MS cannot hinder the exercise of the rights of freedom of movement simply
because of lower levels of taxation in other MS. This is the case even in
respect of special favourable regimes in the other MS' tax systems.

Moreover, distortions to the location of business activities due to EC Treaty
incompatible state aid and to harmful tax competition do not entitle MS to take
unilateral measures intended to counter their effects by limiting freedom of
movement; rather they need to be resolved at source through the appropriate
judicial or political procedures. The Commission will continue to monitor the
application of the EC Treaty state aid rules in the direct tax area and to lend
its full support to the work undertaken in the Council by the Code of Conduct
Group.

Why does the Commission not just litigate?

The number of infringement proceedings begun by the Commission has increased
over the last few years. It is not always necessary for such cases to end up
before the Court because often MS respond by removing the unlawful
restriction.

But while the Commission has the legal obligation to ensure that MS observe
their EC Treaty obligations it also has a political responsibility to seek and
promote constructive tax policy solutions to that end. Moreover, through
constructive solutions we may avoid situations where, in order to avoid the
charge of discrimination, MS resort to extending the application of anti-abuse
measures designed to curb cross-border tax avoidance to purely domestic
situations where no possible risk of abuse exists. Such unilateral remedies only
undermine the competitiveness of the MS' economies, and are not in the interest
of the Internal Market.

What could be achieved in this area by coordination?

Coordination and cooperation between the MS can enable them to attain their
tax policy goals and protect their tax bases while observing their EC Treaty
obligations and ensuring the elimination of double taxation.

It is in the interest of all MS and other stakeholders, that MS remain
capable of operating effective tax systems and that their anti-abuse rules are
accurately targeted at situations of abuse and are predictable and
proportionate. It is also in the general interest of the Internal Market that
the ECJ's case law does not result in more draconian tax systems due to
overreaction on the part of the MS. This could be the case if MS' unilateral
remedies extended existing restrictions on cross-border activities also to
purely domestic operations. Coordination is a flexible approach which can take
many forms and which could provide adequate solutions to challenges faced by the
MS in this area. Therefore the Commission considers it useful to explore the
scope for possible specific co-ordinated solutions with a view to:

developing common definitions for abuse and wholly artificial arrangements
(to provide guidance on the application of those concepts in the direct tax
area);

improving administrative co-operation so as to more effectively detect and
contain abuse and fraudulent tax schemes;

sharing best practices that are compatible with EC law, in particular with a
view to ensuring proportionality of anti-abuse measures;

ensuring better coordination of anti-abuse measures in relation to third
countries.

Why is there a need to distinguish between the
application of anti-abuse rules within the EU and in relation to third
countries?

As regards the EC law compatibility of national anti-abuse measures, a
distinction has to be drawn between their application within the EU/EEA, (where
the four fundamental freedoms apply) and their application vis-à-vis third
countries (where only the free movement of capital applies). The application of
anti-abuse rules targeted at arrangements entered into by corporate groups
beyond the geographical limits of the EU/EEA is thus generally less restricted
by the EC Treaty. Community law does not require MS to avoid discrimination in
relation to the establishment of their nationals outside the Community, or the
establishment of third country nationals in a MS. Therefore, MS should not be
precluded from applying CFC and thin capitalisation rules, for example, in
relation to third countries.

The Commission moreover considers that, in order to protect their tax bases,
MS should seek to improve the coordination of the application of their
anti-abuse measures in particular in respect of international tax avoidance
schemes. Such co-ordination could usefully consist of administrative
co-operation, (e.g. exchange of information and sharing of best practices). The
Commission would also encourage MS, where appropriate, to enhance administrative
co-operation with their non-EU partners.

How does this initiative affect Member States' revenues?

The Commission supports MS' efforts to prevent their tax bases from being
eroded. The possible coordinated solutions should enable the MS to attain their
tax policy goals and protect their tax bases while observing their EC Treaty
obligations. The key objectives of this initiative are indeed to strike a proper
balance between the public interest of combating abuse and the need to avoid
disproportionate restrictions on cross-border activity within the EU as well as
to improve the coordination of the application of MS' anti-abuse rules in
relation to international tax avoidance schemes in order to protect their tax
bases.

How will taxpayers benefit from this initiative?

Taxpayers will benefit not only from the removal of disproportionate
obstacles to their cross-border activities but also from successfully
implemented coordinated solutions through improved clarity and predictability of
the application of anti-abuse rules. It is equally in the interest of taxpayers
if the coordinated solutions can help the MS to avoid extending existing
restrictions on cross-border activities to purely domestic operations. Also,
more generally, that MS remain capable of operating effective tax systems allows
them to meet the requirement of equality – and it is not in the interest
of honest taxpayers to finance the erosion of tax bases due to abusive practices
and overtly aggressive tax planning schemes entered into by others.